A Model of Monopoly - Stanford University · PDF fileexplain some puzzling pricing behavior,...

monopoly decides what price to charge its customers

and what quantity to sell. We also use the model to

explain some puzzling pricing behavior, such as why

some airlines charge a lower fare to travelers who stay

over a Saturday night. Monopolies and the reasons for

their existence raise important public policy questions

about the role of government in the economy. The

model we develop shows that monopolies cause a loss

to society when compared with firms providing goods

in competitive markets; the model also provides a way

to measure that loss. This loss that monopolies cause

to society creates a potential role for government to

step in to try and reduce this loss.

Deciding when to, or whether to, intervene to

break up a monopoly is an extremely complex task,

however. As in the iTunes case or the Microsoft case,

the Department of Justice often is faced with convinc-

ing arguments on both sides of the issue. Companies

that are accused of being monopolists will argue that

their products are simply superior to the competition

and provide a service to consumers. Companies and

governments will disagree on what the appropriate

definition of the ‘‘market’’ is. For instance, Apple

could argue that consumers buy music from a variety

of sources and play it on a variety of different devices;

hence, the iTunes-iPod combination, as popular as it

is, hardly could be considered to be one that restricts

consumer choice. In fact, even governments have a

hard time agreeing with that notion. Shortly after the

European action was announced, Thomas Barnett, a

senior official in the Department of Justice’s Antitrust

Division, said in a speech that ‘‘consumers buy the

expensive iPod device first, then have the option—not

the obligation—to use the free iTunes software and

buy the cheap iTunes songs.’’

Finally, it is important to keep in mind that in the

twenty-first-century economy, monopolies frequently

do not last long. The increased use of the Internet

and the decreased use of software that resides on

one’s own computer greatly reduced concerns about

Microsoft’s monopoly; the rise of cellular phones

made us less concerned about local phone monopo-

lies; satellite television provided competition to your

cable television company’s local monopoly; the tech-

nological advances made by chipmaker AMD eroded

concerns about Intel’s powerful role in the market for

microprocessors. Similarly, as more music players

and different music sales formats are introduced to

the market, concerns about Apple may start to fade.

Nevertheless, some monopolies do last a long time.

De Beers is one of the most famous examples of a

monopoly. It maintained its monopoly position from

1929 well into the 1980s, and even into the 2010s it

controls about half of the diamond market.

A Model of MonopolyA monopoly occurs when only one firm in an industry is selling a product for whichthere are no close substitutes. Thus, implicit in the definition of monopoly are barriersto entry—other firms are not free to enter the industry. For example, De Beers createdbarriers to entry by maintaining exclusive rights to the diamonds in most of the world’sdiamond mines. Microsoft was accused of creating a barrier to entry in software

monopolyone firm in an industry selling aproduct that does not have closesubstitutes.

barriers to entryanything that prevents firms fromentering a market.

A Model of Monopoly 251

production by bundling together its software with the Windows operating system thatcame preinstalled on computers. Sometimes the barriers to entry are artificially createdby the government through systems of copyrights and patents that prevent other firmsfrom duplicating a company’s products. These patents and copyrights allow a companyto earn revenue by licensing the right to produce the particular good that resulted fromthe company’s innovation and creativity.

The economist’s model of a monopoly assumes that the monopoly will choose alevel of output that maximizes profits. In this respect, the model of a monopoly is likethat of a competitive firm. If increasing production will increase a monopoly’s profits,then the monopoly will raise production, just as a competitive firm would. If cutting pro-duction will increase a monopoly’s profits, then the monopoly will cut its production,just as a competitive firm would.

The difference between a monopoly and a competitive firm is not what motivatesthe firm but rather how its actions affect the market price. The most important differenceis that a monopoly has market power. That is, a monopoly has the power to set theprice in the market, whereas a competitor does not. This is why a monopoly is called aprice-maker rather than a price-taker, the term used to refer to a competitive firm.

Getting an Intuitive Feel for theMarket Power of a MonopolyWe can demonstrate the monopoly’s power to affect the price in the market by lookingat either what happens when the monopoly changes its price or what happens when themonopoly changes the quantity it produces. We consider the price decision first.

No One Can Undercut the Monopolist’s Price When several sellers arecompeting with one another in a competitive market, one seller can try to sell at ahigher price, but no one will buy at that price because another seller is always nearbywho will undercut that price. If a seller charges a higher price, everyone will ignorethat seller; there is no effect on the market price.

The monopoly’s situation is quite different. Instead of several sellers, the market hasonly one seller. If the single seller sets a high price, it has no need to worry about beingundercut by other sellers. There are no other sellers. Thus, the single seller—themonopoly—has the power to set a high price. True, the buyers probably will buy less atthe higher price—that is, as the price rises, the quantity demanded declines—but becauseno other sellers offer that product or service, they probably will buy something from thelone seller.

The Impact of Quantity Decisions on the Price Another way to see thisimportant difference between a monopoly and a competitor is to examine what happensto the price when a firm changes the quantity it produces. Suppose that 100 firms arecompeting in the bagel-baking market in a large city, each producing about the samequantity of bagels each day. Suppose that one of the firms—Bageloaf—decides to cut itsproduction in half. Although this is a huge cut for one firm, it is a small cut comparedwith the whole market—only 0.5 percent. Thus, the market price will rise very little.Moreover, if this little price increase affects the behavior of the other 99 firms at all, itwill motivate them to increase their production slightly. As they increase the quantitythey supply, they partially offset the cut in supply by Bageloaf, and so the change in mar-ket price will be even smaller. Thus, by any measure, the overall impact on the price fromthe change in Bageloaf’s production is negligible. Bageloaf essentially has no power toaffect the price of bagels in the city.

The monopoly power of the saltindustry has been illustratedthroughout history. Salt monopolieshave contributed to the rise of severalstate powers—from governments inancient China to medieval Europe,where Venice’s control of the saltmonopoly helped finance its navyand allowed it to dominate worldtrade.

market powera firm’s power to set its pricewithout losing its entire share ofthe market.

price-makera firm that has the power to set itsprice, rather than taking the priceset by the market.

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252 Chapter 10 Monopoly

But now suppose that Bageloaf and the 99 other firms are taken over by Bagelopoly,which then becomes the only bagel bakery in the city. Now, if Bagelopoly cuts produc-tion in half, the total quantity of bagels supplied to the whole market is cut in half, andthis will have a big effect on the price in the market.

If Bagelopoly cut its production even further, the price would rise further. If Bage-lopoly increased the quantity it produced, however, the price of bagels would fall. Thus,Bagelopoly has immense power to affect the price. Even if Bagelopoly does not knowexactly what the price elasticity of demand for bagels is, it can adjust the quantity it willproduce either up or down to change the price.

Showing Market Power with a Graph Figure 10-1 contrasts the marketpower of a monopoly with that of a competitive firm. The right-hand graph shows thatthe competitive firm views the market price as essentially out of its control. The marketprice is shown by the flat line and is thus the same regardless of how much the firm pro-duces. If the competitive firm tried to charge a higher price, nobody would buy becausemany competitors would be charging a lower price; so, effectively, the competitive firmcannot charge a higher price.

To a monopoly, on the other hand, things look quite different. Because themonopoly is the sole producer of the product, it represents the entire market. Themonopoly—shown in the left-hand graph—sees a downward-sloping market demand

Figure 10-1How the Market Power of a Monopoly and a Competitive Firm DifferA monopoly is the only firm in the market. Thus, the market demand curve and the demand curve of the monopoly are the same.By raising the price, the monopoly sells less. In contrast, the competitive firm has no impact on the market price. If thecompetitive firm charges a higher price, its sales will drop to zero because many other sellers offer identical products.

D

QUANTITY

PRICE

Demand curve slopesdown, showing marketpower.

A Monopoly’s View

D

QUANTITY

PRICE

A Competitive Firm’s View

Demand curve is flat,showing no marketpower.


curve for its product. The downward-sloping demand curve seen by the monopoly is thesame as the market demand curve. If the monopoly charges a higher price, the quantitydemanded declines along the demand curve. With a higher price, fewer people buy theitem, but with no competitors to undercut that higher price, some demand still exists forthe product. The difference in the market power of a monopoly and a competitivefirm—illustrated by the slope of the demand curve each faces—causes the difference inthe behavior of the two types of firms.

The Effects of a Monopoly’s Decision on RevenuesNow that we have seen how the monopoly can affect the price in its market by changingthe quantity it produces, let’s see how its revenues are affected by the quantity itproduces.

Table 10-1 gives a specific numerical example of a monopoly. Depending on the unitsfor measuring the quantity Q , the monopoly could be producing software, computerchips, or diamonds. The two columns on the left represent the market demand curve,showing a negative relationship between the price and the quantity sold: As the price fallsfrom $130 to $120 per unit, for example, the quantity sold rises from three to four.

Total Revenue and Marginal Revenue The third column of Table 10-1shows what happens to the monopoly’s total revenue, or price times quantity, as thequantity of output increases. Observe that at the beginning, when the monopolyincreases the quantity produced, total revenue rises: When zero units are sold, total reve-nue is clearly zero; when one unit is sold, total revenue is 1 � $150, or $150; when twounits are sold, total revenue is 2 � $140, or $280; and so on. As the quantity soldincreases, however, total revenue rises by smaller and smaller amounts and eventually

Table 10-1Revenue, Costs, and Profits for a Monopoly (price, revenue, and cost measuredin dollars)

Market Demand

QuantityProducedand Sold

(Q)Price

(P)

TotalRevenue

(TR)

MarginalRevenue

(MR)

TotalCosts(TC)

MarginalCost(MC) Profits

0 160 0 — 70 — �701 150 150 150 79 9 712 140 280 130 84 5 1963 130 390 110 94 10 2964 120 480 90 114 20 3665 110 550 70 148 34 4026 100 600 50 196 48 4047 90 630 30 261 65 3698 80 640 10 351 90 2899 70 630 �10 481 130 149

10 60 600 �30 656 175 �56

TR� TCTR ¼ P 3 Q Change in TRChange in Q

Change in TCChange in Q


starts to fall. In Table 10-1, total revenue reaches a peak of $640 at eight units sold andthen starts to decline.

Marginal revenue, introduced in Chapter 6, is the change in total revenue from onemore unit of output sold. For example, if total revenue increases from $480 to $550 asoutput rises by one unit, marginal revenue is $70 ($550 � $480 ¼ $70). Marginal reve-nue for the monopolist in Table 10-1 is shown in the fourth column, next to total reve-nue. In addition, marginal revenue is plotted in the right-hand graph of Figure 10-2,where it is labeled MR.

The left-hand graph in Figure 10-2 shows how total revenue changes with the quan-tity of output for the example in Table 10-1. It shows that total revenue increases by asmaller and smaller amount, reaches a maximum, and then begins to decline. In otherwords, marginal revenue declines as the quantity of output rises and eventually becomesnegative. So, although a monopolist has the power to influence the price, this does notmean that it can get as high a level of total revenue as it wants.

Why does total revenue increase by smaller and smaller amounts and then decline asproduction increases? To sell more output, the monopolist must lower the price to getpeople to buy the increased output. As it raises output, it must lower the price more andmore, and this causes the increase in total revenue to get smaller. As the price falls tovery low levels, revenue actually declines.

Figure 10-2Total Revenue, Marginal Revenue, and DemandThe graph on the left plots total revenue for each level of output in Table 10-1. Total revenue first rises and then declines as thequantity of output increases. Marginal revenue is the change in total revenue for each additional increase in the quantity of outputand is shown by the orange curve at the right. Observe that the marginal revenue curve lies below the demand curve at each levelof output except Q ¼ 1.

91 82 6 7 1043 5

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400

300

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100

0

DOLLARS

QUANTITY

Change in TR = 50Change in Q = 1

Slope = MR = 50

Change in TR = 130Change in Q = 1

Slope = MR = 130

1 92 5 83 6 74 10

200

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50

0

−50

DOLLARS

QUANTITY QUANTITY

Marginal revenue (MR )

Demand

MR = 50

MR = 130


Marginal Revenue Is Less Than the Price Another important relationshipbetween marginal revenue and price is that for every level of output, marginal revenue isless than the price (except at the first unit of output, where it equals the price). Toobserve this, compare the price (P) and marginal revenue (MR) in Table 10-1 or in theright-hand panel of Figure 10-2.

Note that the green line in Figure 10-2 showing the price and the quantity of out-put demanded is simply the demand curve facing the monopolist. Thus, another way tosay that marginal revenue is less than the price at a given level of output is to say that themarginal revenue curve lies below the demand curve.

Why is the marginal revenue curve below the demand curve? When the monopolistincreases output by one unit, there are two effects on total revenue: (1) a positive effect,which equals the price P times the additional unit sold, and (2) a negative effect, whichequals the reduction in the price on all items previously sold times the number of suchitems sold. For example, as the monopolist in Table 10-1 increases production from fourto five units and the price falls from $120 to $110, marginal revenue is $70. This $70 isequal to the increased revenue from the extra unit produced, or $110, less the decreasedrevenue from the reduction in the price, or $40 ($10 times the four units previously pro-duced). Marginal revenue (MR ¼ $70) is thus less than the price (P ¼ $110). The twoeffects on marginal revenue are shown in the graph in the margin when quantityincreases from 3 to 4. Because the second effect—the reduction in revenue due to thelower price on the items previously produced—is subtracted from the first, the price isalways greater than the marginal revenue.

Marginal Revenue and Elasticity Marginal revenue is negative when the priceelasticity of demand is less than one. To see this, some algebra is helpful. Note from theexamples in the table below that the following equation holds:

MR ¼ (P � DQ) � (DP � Q)

If MR < 0, then

P � DQ < DP � Q

which implies that

DQ=Qð ÞDP=Pð Þ < 1

or, in words, that the price elasticity of demand is less than one. Because it would becrazy for a monopolist to produce so much that its marginal revenue was negative, we

QuantitySold

MarginalRevenue

(MR)

Price 3Change inQuantity

� ��

Changein

Price

0@

1A 3

PreviousQuantity

Sold

0@

1A

P � (DQ) (DP) � (Q)

1 150 ¼ $150 � 1 � $10 � 0

2 130 ¼ $140 � 1 � $10 � 13 110 ¼ $130 � 1 � $10 � 24 90 ¼ $120 � 1 � $10 � 3

5 70 ¼ $110 � 1 � $10 � 46 50 ¼ $100 � 1 � $10 � 57 30 ¼ $ 90 � 1 � $10 � 6

8 10 ¼ $ 80 � 1 � $10 � 79 �10 ¼ $ 70 � 1 � $10 � 8

10 �30 ¼ $ 60 � 1 � $10 � 9

71 82 93 5 64 10

200

150

100

50

0

PRICE (P )(DOLLARS)

QUANTITY (Q )

P = $130

P =$120

Demand

Graph Showing the Two Effects onMarginal Return

When the monopoly raises outputfrom three units to four units,revenue increases; that is, marginalrevenue is greater than zero. Thereis a positive effect (grey rectangle)because one more item is sold anda negative effect (orange rectangle)because prices on the first threeunits fall. Here the positive effect ofthe sale of an extra unit at $120(grey) is greater than the negativeeffect of selling each of the firstthree units at a price that is $10 lessthan before (orange), so marginalrevenue is $120 � $30 ¼ $90.


conclude that a monopoly would never produce a level of output for which the priceelasticity of demand would be less than one.

Average Revenue We also can use average revenue to show that marginal revenueis less than the price. Average revenue is defined as total revenue divided by the quan-tity of output; that is, AR ¼ TR/Q . Because total revenue (TR) equals price timesquantity (P � Q), we can write average revenue (AR) as (P � Q)/Q or, simply, the priceP. In other words, the demand curve—which shows price at each level of output—alsoshows average revenue for each level of output.

Now recall from Chapter 8 that when the average of anything (costs, grades,heights, or revenues) declines, the marginal must be less than the average. Thus, becauseaverage revenues (prices) decline (that is, the demand curve slopes down), the marginalrevenue curve must lie below the demand curve.

Finding Output to Maximize Profits at the MonopolyNow that we have seen how a monopoly’s revenues depend on the quantity it produces,let’s see how its profits depend on the quantity it produces. Once we identify the rela-tionship between profit and the quantity the monopoly will produce, we can determinethe level of output that maximizes the monopoly’s profits. Revenues alone cannot deter-mine how much a firm produces. For instance, we know that a monopolist will neverproduce a quantity for which marginal revenue is negative. But that does not mean thatit will produce until marginal revenue is zero. Even if each additional unit brings in extrarevenue, the firm will have to look at the costs of producing that extra unit as well.

The last three columns of Table 10-1 show the costs and profits for the examplemonopoly. There are no new concepts to introduce about costs for a monopoly, so wecan continue to use the cost measures we developed in Chapters 7 to 9. The most im-portant features to note are that total costs increase as more is produced and that mar-ginal cost also increases, at least for high levels of output.

Comparing Total Revenue and Total Costs The difference between totalrevenue and total costs is profits. Observe in Table 10-1 that as the quantity producedincreases, both the total revenue from selling the product and the total costs of produc-ing the product increase. At some level of production, however, total costs start toincrease more than revenue increases, so that eventually profits must reach a maximum.

A quick glance at the profits column in Table 10-1 shows that this maximum levelof profits is $404 and is reached when the monopoly produces six units of output. Theprice the monopoly must charge so that people will buy six units of output is $100,according to the second column of Table 10-1. To help you visualize how profits changewith quantity produced and to find the maximum level of profits, Figure 10-3 plots totalcosts, total revenue, and profits from Table 10-1. Profits are shown as the gap betweentotal costs and total revenue. The gap reaches a maximum when output Q equals six.

Equating Marginal Cost and Marginal Revenue Economists use an alter-native, more intuitive approach to finding the level of production that maximizes amonopolist’s profits. This approach looks at marginal revenue and marginal cost andemploys a rule that economists use extensively.

Consider producing different levels of output, starting with one unit and then risingunit by unit. Compare the marginal revenue from selling each additional unit of outputwith the marginal cost of producing it. If the marginal revenue is greater than the mar-ginal cost of the additional unit, then profits will increase if the unit is produced. Thus,the unit should be produced, because total revenue rises by more than total costs. Forexample, in Table 10-1, the marginal revenue from producing one unit of output is

average revenuetotal revenue divided by quantity.


$150 and the marginal cost is $9, so producing that unit increases profits by $141. Thus,at least one unit should be produced. What about two units? Then marginal revenueequals $130 and marginal cost equals $5, so that second unit adds $125 to profits,meaning that it makes sense to produce two units.

Continuing this way, the monopolist should increase its output as long as marginalrevenue is greater than marginal cost. But because marginal revenue is decreasing, atsome level of output, marginal revenue will drop below marginal cost. The monopolistshould not produce at that level. For example, in Table 10-1, the marginal revenue fromselling seven units of output is less than the marginal cost of producing it. Thus, themonopolist should not produce seven units; instead, six units of production, with MR ¼50 and MC ¼ 48, is the profit-maximization level. This is the highest level of output forwhich marginal revenue is greater than marginal cost. Note that this level of output isexactly what we obtain by looking at the gap between total revenue and total costs.

Thus, the monopolist should produce up to the level of production at which marginalcost equals marginal revenue (MC ¼ MR). If the level of production cannot be adjustedso exactly that marginal revenue is precisely equal to marginal cost, then the firm shouldproduce at the highest level of output for which marginal revenue exceeds marginal cost,as in Table 10-1. In most cases, the monopoly will be able to adjust its output by smallerfractional amounts (for example, pounds of diamonds rather than tons of diamonds),and therefore marginal revenue will equal marginal cost.

A picture of how this marginal revenue equals marginal cost rule works is shown inFigure 10-4. The marginal revenue curve is plotted, along with the marginal cost curve.As the quantity produced increases above very low levels, the marginal cost curve slopesup and the marginal revenue curve slopes down. Marginal revenue equals marginal costat the level of output at which the two curves intersect.

Figure 10-3Finding a Quantity of Output to Maximize ProfitsProfits are shown as the gap between total revenue and total costs in the graph on the left and are plotted on the graph on theright. Profits are at a maximum when the quantity of output is six.

100 91 82 73 64 5

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DOLLARS DOLLARS

QUANTITY QUANTITY

Total revenues

Profits

Total costs

Profits are maximized here.

100 91 82 73 64 5

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−100

Maximum profits= $404

Next highestprofits = $402

Profits


MC ¼MR at a Monopoly versus MC ¼ Pat a Competitive FirmIt is useful to compare the MC ¼ MR rule for the monopolist with the MC ¼ P rule forthe competitive firm that we derived in Chapter 6.

Marginal Revenue Equals the Price for a Price-Taker For a competi-tive firm, total revenue is equal to the quantity sold (Q) multiplied by the market price (P),but the competitive firm cannot affect the price. Thus, when the quantity sold is increasedby one unit, revenue is increased by the price. In other words, for a competitive firm, mar-ginal revenue equals the price; to say that a competitive firm sets its marginal cost equal tomarginal revenue is to say that it sets its marginal cost equal to the price. Thus, the MC ¼MR rule applies to both monopolies and competitive firms that maximize profits.

A Visual Comparison Figure 10-5 is a visual comparison of the two rules. Amonopoly is shown on the right graph of Figure 10-5. We drew this kind of graph inFigure 10-3 except that it applies to any firm, so we do not show the units. A competi-tive firm is shown in the left graph of Figure 10-5. The scale on these two figures mightbe quite different; only the shapes are important for this comparison.

Look carefully at the shape of the total revenue curve for the monopoly and contrastit with the total revenue curve for the competitive firm. The total revenue curve for themonopoly starts to turn down at higher levels of output, whereas the total revenue curvefor the competitive firm keeps rising in a straight line.

To illustrate the maximization of profits, we have put the same total costs curve onboth graphs in Figure 10-5. Both types of firms maximize profits by setting productionso that the gap between the total revenue curve and the total costs curve is as large aspossible. That level of output, the profit-maximizing level, is shown for both firms.

Figure 10-4

1 92 83 74 5 6 10

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DOLLARS

QUANTITY

Marginal cost (MC)

Demand

Marginalrevenue (MR)

Marginal Revenue andMarginal CostThe profit-maximizing monopolywill produce up to the point atwhich marginal revenue equalsmarginal cost, as shown in thediagram. If fractional unitscannot be produced, then themonopoly will produce at thehighest level of output for whichmarginal revenue is greater thanmarginal cost. These curves aredrawn for the monopoly in Table10-1.


Higher or lower levels of output will reduce profits, as shown by the gaps between totalrevenue and total costs in the diagrams.

Observe that at the profit-maximizing level of output, the slope of the total costscurve is equal to the slope of the total revenue curve. Those of you who are mathemati-cally inclined will notice that the slope of the total costs curve is how much total costschange when quantity is increased by one unit—that is, the marginal cost. Similarly, theslope of the total revenue curve is the marginal revenue—the increase in total revenuewhen output increases by one unit. Thus, we have another way of seeing that marginalrevenue equals marginal cost for profit maximization.

For the competitive firm, marginal revenue is the price, which implies the conditionof profit maximization at a competitive firm derived in Chapter 6: Marginal cost equalsprice. For the monopolist, however, marginal revenue and price are not the same thing.

Figure 10-5Profit Maximization for a Monopoly and a Competitive FirmTotal revenue for a competitive firm rises steadily with the amount sold; total revenue for a monopoly first rises and then falls.However, both the monopolist and the competitor maximize profits by making the gap between the total costs curve and the totalrevenue curve as large as possible or by setting the slope of the total revenue curve equal to the slope of the total costs curve.Thus, marginal revenue equals marginal cost. For the competitive firm, marginal revenue equals the price.

Total costs

Total costs

Total revenue

Total revenue

MaximumMaximum

QUANTITYQUANTITY

PRICE PRICE

Slope equals price.

Slope equalsmarginal cost.

Competitive Firm Monopoly

Slope equalsmarginal revenue.

Slope equalsmarginal cost.

R E V I E W• When one firm is the sole producer of a product with

no close substitutes, it is a monopoly. Most monopo-lies do not last forever. They come and go as technol-ogy changes. Barriers to the entry of new firms areneeded to maintain a monopoly.

• A monopoly is like a competitive firm in that it triesto maximize profits. But unlike a competitive firm, amonopoly has market power; it can affect the marketprice. The demand curve that the monopoly faces isthe same as the market demand curve.


The Generic Diagram of a Monopolyand Its ProfitsLook at Figure 10-6, which combines the monopoly’s demand and marginal revenuecurves with its average total cost curve and marginal cost curve. This diagram is theworkhorse of the model of a monopoly, just as Figure 8-6 in Chapter 8 is the workhorseof the model of a competitive firm. As with the diagram for a competitive firm, youshould be able to draw it in your sleep. It is a generic diagram that applies to any monop-olist, not just the one in Table 10-1, so we do not put scales on the axes.

Observe that Figure 10-6 shows four curves: a downward-sloping demand curve(D), a marginal revenue curve (MR), an average total cost curve (ATC), and a marginalcost curve (MC). The position of these curves is important. First, the marginal cost curvecuts through the average total cost curve at the lowest point on the average total costcurve. Second, the marginal revenue curve is below the demand curve over the entirerange of production (except at the vertical axis near one, where they are equal).

We already have given the reasons for these two relationships (in Chapter 8 and inthe previous section of this chapter), but it would be a good idea for you to practicesketching your own diagram like Figure 10-6 to ensure that the positions of your curvesmeet these requirements.1

Determining Monopoly Output and Price on the DiagramIn Figure 10-6 we show how to calculate the monopoly output and price. First, find thepoint of intersection of the marginal revenue curve and the marginal cost curve. Second,draw a dashed vertical line through this point and look down the dashed line at the hori-zontal axis to figure out the quantity produced. Producing a larger quantity would lowermarginal revenue below marginal cost. Producing a smaller quantity would raise

• Marginal revenue is the change in total revenue asoutput increases by one unit. Marginal revenuedeclines as quantity sold increases and may evenbecome negative at some level of output.

• Marginal revenue is less than the price at each levelof output (except the first). If we lower the price toincrease the quantity sold by one unit, revenueincreases by the amount of the sale price of thegood, but revenue also decreases because the otherunits are now selling at a lower price.

• A monopolist will never produce at a quantity forwhich marginal revenue is negative. But it also willnot produce until marginal revenue equals zero.Even if an additional unit brings in extra revenue, thefirm’s decision to produce depends on how much itcosts to produce that extra unit.

• The profit-maximizing quantity for a firm toproduce is the quantity for which marginal revenueequals marginal cost (MR ¼ MC). As long asMR > MC, the firm should keep producing, andif MR < MC, the firm should not produce thatadditional unit.

• For a competitive firm, marginal revenue equalsprice, because the firm cannot affect the price byincreasing the quantity it sells. So marginal costequals price, which in turn equals marginal revenue(MR ¼ MC ¼ P).

• For a monopoly, marginal revenue also equals mar-ginal cost, but marginal revenue does not equal theprice. Hence, for the monopolist, price is not neces-sarily equal to marginal cost.

1 When sketching diagrams, it is useful to know that when the demand curve is a straight line, the marginal rev-enue curve is always twice as steep as the demand curve and, if extended, would cut the horizontal axis exactlyhalfway between zero and the point at which the demand curve would cut the horizontal axis.

The Generic Diagram of a Monopoly and Its Profits 261

marginal revenue above marginal cost. The quantity shown is the profit-maximizinglevel. It is the amount the monopolist produces.

What price will the monopolist charge? We again use Figure 10-6, but be careful:Unlike the quantity, the monopolist’s price is not determined by the intersection of themarginal revenue curve and the marginal cost curve. The price has to be such that thequantity demanded is equal to the quantity that the monopolist decides to produce. Tofind the price, we need to look at the demand curve in Figure 10-6. The demand curvegives the relationship between price and quantity demanded. It tells how much themonopolist will charge for its product to sell the amount produced.

To calculate the price, extend the dashed vertical line upward from the point ofintersection of the marginal cost curve and the marginal revenue curve until it intersectsthe demand curve. At the intersection of the demand curve and the vertical line, we findthe price that will generate a quantity demanded equal to the quantity produced. Nowdraw a horizontal line over to the left from the point of intersection to mark the price onthe vertical axis. This is the monopoly’s price, about which we will have more to saylater.

Determining the Monopoly’s ProfitsProfits also can be shown on the diagram in Figure 10-6. Profits are given by the differ-ence between the area of two rectangles, a total revenue rectangle and a total costs rec-tangle. Total revenue is price times quantity and thus is equal to the area of the rectanglewith height equal to the monopoly price and length equal to the quantity produced.Total costs are average total cost times quantity and thus are equal to the area of the rec-tangle with height equal to ATC and length equal to the quantity produced. Profits arethen equal to the blue-shaded area that is the difference between these two rectangles.

Figure 10-6

Demand (D)

3. The price isfound on thedemand curve.

2. The quantity produced is here.

4. Monopolypriceis here.

Marginal revenue (MR)

Average totalcost (ATC)

Marginal cost (MC)

QUANTITY

PRICE Average totalcost isfound on theATC curve.

5.

1. Marginal cost equalsmarginal revenue here.

6. Profits are inthe rectangle.

The Generic Diagram fora MonopolyThe marginal revenue anddemand curves are superimposedon the monopoly’s cost curves.The monopoly’s production, price,and profits can be seen on thesame diagram. Quantity is givenby the intersection of the marginalrevenue curve and the marginalcost curve. Price is given by thedemand curve at the pointcorresponding to the quantityproduced, and average total costis given by the ATC curve at thatquantity. Monopoly profits aregiven by the rectangle that is thedifference between total revenueand total costs.


It is possible for a monopoly to have negative profits, or losses, as shown in Figure10-7. In this case, the price is below average total cost, and therefore total revenue is lessthan total costs. Like a competitive firm, a monopolist with negative profits will shutdown if the price is less than average variable cost. It eventually will exit the market ifnegative profits persist.

Competition, Monopoly, andDeadweight LossAre monopolies harmful to society? Do they reduce consumer surplus? Can we measurethese effects? To answer these questions, economists compare the price and output ofa monopoly with those of a competitive industry. First, observe in Figure 10-6 and

Figure 10-7

Marginal revenue (MR )

Average totalcost (ATC )

Marginalcost (MC )

Demand

Quantity produced

Monopolyprice

Negative profits (losses) arein this rectangle (P < ATC ).

QUANTITY

PRICE A Monopoly withNegative ProfitsIf a monopoly finds that averagetotal cost is greater than theprice at which marginal revenueequals marginal cost, then it runslosses. If price is also less thanaverage variable cost, then themonopoly should shut down,just like a competitive firm.

R E V I E W• A monopolist’s profit-maximizing output and price

can be determined graphically. The diagram showsfour curves: the marginal revenue curve, the demandcurve, the marginal cost curve, and the average totalcost curve.

• The monopoly’s production is determined at the pointat which marginal revenue equals marginal cost.

• The monopoly’s price is determined fromthe demand curve at the point at which the

quantity produced equals the quantitydemanded.

• The monopoly’s profits are determined bysubtracting the total costs rectangle from the totalrevenue rectangle. The total revenue rectangle isgiven by the price times the quantity produced. Thetotal costs rectangle is given by the average totalcost times the quantity produced.

Competition, Monopoly, and Deadweight Loss 263

Figure 10-7 that the monopoly does not operate at the minimum point on the averagetotal cost curve even in the long run. Recall that firms in a competitive industry do operateat the lowest point on the average total cost curve in the long run. To go further in ourcomparison, we use Figure 10-8, which is a repeat of Figure 10-6, except that the averagetotal cost curve is removed to reduce the clutter. All the other curves are the same.

Comparison with CompetitionSuppose that instead of only one firm being in the market, it now includes many com-petitive firms. For example, suppose Bagelopoly—a single firm producing bagels in alarge city—is broken down into 100 different bagel bakeries like Bageloaf. The produc-tion point for the monopolistic firm and its price before the breakup are marked as‘‘monopoly quantity’’ and ‘‘monopoly price’’ in Figure 10-8. What are production andprice after the breakup?

The market supply curve for the new competitive industry would be Bagelopoly’sold marginal cost curve, because this is the sum of the marginal cost curves of all thenewly created firms in the industry. Equilibrium in the competitive industry is the pointat which this market supply curve crosses the market demand curve. The amount of pro-duction at that point is marked by ‘‘competitive quantity’’ in Figure 10-8. The price atthat equilibrium is marked by ‘‘competitive price’’ on the vertical axis.

Compare the quantity and price for the monopolist and the competitive industry. Itis clear that the quantity produced by the monopolist is less than the quantity producedby the competitive industry. It also is clear that the monopoly will charge a higher pricethan will emerge from a competitive industry. In sum, the monopoly produces less andcharges a higher price than the competitive industry would.

Figure 10-8

Monopoly quantity Competitive quantity

Monopolyprice

Intersection of market demand andmarket supply gives competitive output.

DemandMR

QUANTITY

PRICE

Competi-tive price

Deadweight lossdue to monopoly

This amount of consumer surplusis turned into producer surplus.

Intersection of marginalrevenue and marginal costgives monopoly output.

Marginal cost ( MC ) for monopoly = sum of the marginal costs for eachof the competitive firms = marketsupply curve for competitive industry.

Deadweight Loss fromMonopolyThe monopolist’s output andprice are determined as in Figure10-6. To get the competitiveprice, we imagine thatcompetitive firms make up anindustry supply curve that is thesame as the monopolist’smarginal cost curve. Thecompetitive price and quantityare given by the intersection ofthe supply curve and the demandcurve. The monopoly quantity islower than the competitivequantity. The monopoly price ishigher than the competitive price.The deadweight loss is thereduction in consumer plusproducer surplus because of thelower level of production by themonopolist.


This is an important result. The monopoly exploits its market power by holdingback on the quantity produced and causing the price to rise compared with the competi-tive equilibrium. This is always the case. Convince yourself by drawing different dia-grams. For example, when De Beers exercises its market power, it holds back productionof diamonds, thereby raising the price and earning economic profits.

Even though the monopoly has the power to do so, it does not increase its pricewithout limit. When the price is set very high, marginal cost rises above marginal reve-nue. That behavior is not profit maximizing.

Deadweight Loss from MonopolyThe economic harm caused by a monopoly occurs because it produces less than a com-petitive industry would. How harmful, then, is a monopoly?

Consumer Surplus and Producer Surplus Again Economists measurethe harm caused by monopolies by the decline in the sum of consumer surplus plus pro-ducer surplus. Recall that consumer surplus is the area above the market price line andbelow the demand curve, the demand curve being a measure of consumers’ marginalbenefit from consuming the good. The producer surplus is the area above the marginalcost curve and below the market price line. Consumer surplus plus producer surplus isthus the area between the demand curve and the marginal cost curve. It measures thesum of the marginal benefits to consumers of the good less the sum of the marginal coststo the producers of the good. A competitive market will maximize the sum of consumerplus producer surplus.

With a lower quantity produced by a monopoly, however, the sum of consumer sur-plus and producer surplus is reduced, as shown in Figure 10-8. This reduction in con-sumer plus producer surplus is called the deadweight loss due to monopoly. It is aquantitative measure of the harm a monopoly causes the economy. A numerical exampleis given in the margin.

How large is the deadweight loss in the U.S. economy? Using the method illustratedin Figure 10-8, empirical economists estimate that the loss is between 0.5 and 2 percentof gross domestic product (GDP), or between $60 billion and $240 billion, per year. Ofcourse, the deadweight loss is a larger percentage of production in industries in whichmonopolies have a greater presence.

Figure 10-8 also shows that the monopoly takes, in the form of producer surplus,some of the consumer surplus that would have gone to the consumers in competitivemarkets. Consumer surplus is now the area below the demand curve and above themonopoly price, which is higher than the competitive price. This transfer of consumersurplus to the monopoly is not a deadweight loss, however, because what the consumerslose, the monopoly gains. This transfer affects the distribution of income, but it is not anet loss to society.

Meaningful Comparisons In any given application, we need to be careful thatthe comparison of monopoly and competition makes sense. Some industries cannot bebroken up into many competitive firms without changing the cost structure of the indus-try. For instance, having 100 sewer companies laying down pipes to serve one local areawould be costly. Therefore, transforming a monopolistic sewer industry into a competi-tive sewer industry is unlikely to lead to greater societal benefits. Instead, we should tryto affect the monopoly’s decisions by government actions.

We also should be careful about concluding that a competitive industry of one typeis preferable to a monopolistic industry of another type. History provides many suchexamples. Western settlers in the United States during the nineteenth century had a

15

10

5

2 4 6 8 10 12 14 16 18 20

Demand = MBDOLLARS

QUANTITY

MCMR

5 4 3 2 1

Numerical Example of DeadweightLoss Calculation

The monopoly shown in the diagramabove produces only 12 items, buta competitive industry wouldproduce 18 items. For the 13ththrough 17th items, which are notproduced by the monopoly, themarginal benefit is greater than themarginal cost by the amounts $5, $4,$3, $2, and $1, respectively, as shownby the areas between the demandcurve and the supply curve for thecompetitive industry. Hence, thedeadweight loss caused by themonopoly is the sum $5þ $4þ $3þ$2þ $1¼ $15.

Competition, Monopoly, and Deadweight Loss 265

larger consumer surplus from railroads—in spite of the railroad monopolists’ profits—than they did from competitive wagon trains. Modern-day users of the information high-way—computers and telecommunications—reap a larger consumer surplus from Micro-soft’s software and Intel’s computer chips, even if they are produced monopolistically,than they would from a competitive pocket calculator industry.

The Monopoly Price Is Greater Than Marginal CostAnother way to think about the loss to society from monopoly is to observe the differ-ence between price and marginal cost. Figure 10-8, for example, shows that themonopoly price is well above the marginal cost at the quantity at which the monopolyproduces.

Marginal Benefit Is More Than Marginal Cost Because consumers willconsume up to the point at which the marginal benefit of a good equals its price, the ex-cessive price means that the marginal benefit of a good is greater than the marginal cost.This is inefficient because producing more of the good would increase benefits to con-sumers by more than the cost of producing it.

The size of the difference between price and marginal cost depends on the elasticityof the monopoly’s demand curve. If the demand curve is highly elastic (close to a com-petitive firm’s view as shown in Figure 10-1), then the difference between price and mar-ginal cost is small.

The Price-Cost Margin A common measure of the difference between price andmarginal cost is the price-cost margin. It is defined as

Price�marginal costPrice

For example, if the price is $4 and the marginal cost is $2, the price-cost margin is(4 � 2)/4 ¼ 0.5. The price-cost margin for a competitive firm is zero because priceequals marginal cost. Economists use a rule of thumb to show how the price-cost margindepends on the price elasticity of demand. The rule of thumb is shown in the equationbelow.

Price-cost margin ¼ 1price elasticity of demand

For example, when the elasticity of demand is two, the price-cost margin is 0.5. The flatdemand curve has an infinite elasticity, in which case the price-cost margin is zero; inother words, price equals marginal cost.

R E V I E W• A monopoly creates a deadweight loss because it

restricts output below what the competitive marketwould produce. The cost is measured by the dead-weight loss, which is the reduction in the sum ofconsumer plus producer surplus.

• Sometimes the comparison between monopoly andcompetition is only hypothetical because it would

either be impossible or make no sense to break upthe monopoly into competitive firms.

• Another way to measure the impact of a monopoly is bythe difference between price and marginal cost.Monopolies always charge a price higher than marginalcost. The difference—summarized in the price-costmargin—depends inversely on the elasticity of demand.

price-cost marginthe difference between price andmarginal cost divided by the price.This index is an indicator ofmarket power, where an index ofzero indicates no market powerand a higher price-cost marginindicates greater market power.


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